It's a Tough Slog, but Productive

Although the markets have given back a lot of gains since the US elections, much of the uncertainties of the markets are being resolved and economies are slowly clawing back observes John Stephenson in Strategic Investor.

The S&P 500 has tumbled 5% since Election Day, as worries about America’s approaching fiscal cliff have overrun investors. But markets are supposed to be not only rational, but also forward looking, so why now are the worries about fiscal drag surfacing?

After all, the market has known for months that this cliff was coming. Surely, all the worry over Obama's heavier regulatory hand in telecom, energy, and banking must have been priced into the market well before the first debate, when it looked certain that his lead over challenger Mitt Romney was all but insurmountable.

Beyond the Washington beltway, the reasons for the recent slump in equities are piling up. The darkening cloud over Europe, a region that accounts for 15% of the S&P500 profits, is a big contributor to the malaise. Not to mention the lackluster third-quarter earnings and the dismal guidance for the fourth quarter have all taken their toll on investors.

Throw in the huge slump in Apple (AAPL) shares as well as those at Dell (DELL), which tumbled to their lowest price in three years after four consecutive quarters of declining sales. The dismal results for technology companies have managed to dent the largest component of the benchmark index.

Meanwhile, President Obama met congressional leaders last Friday to start hammering out a deal to avert automatic spending cuts and tax hikes that are set to kick in at the start of next year. In a debate that often focuses on raising tax rates or cutting social programs, tax breaks are often ignored. These provisions are very large; in 2012, the biggest ones will total more than $800 billion, greater than the spending on defense or Medicare.

Deductions such as mortgage interest, health care contributions by employers, charitable deductions, and earned income credit are sacred cows that both parties would be reluctant to attack. But these measures, which now number more than 200, may be up for grabs in the heated debate over America’s finances.

But despite the machinations over the fiscal cliff, the softness in Europe, and dismal performance by some tech companies, stock-market returns are overwhelmingly determined by the business cycle. Much of the debate has been centered on dividend stocks and Obama’s plan for higher tax rates on those payouts.

But a closer look at dividend payers reveals that they in fact have not been underperforming the broad market of late. In part, this is because a large proportion of US equity assets (some 45%) are in tax-advantaged retirement accounts, which are indifferent to the current tax-rate discussion.

Despite the common perception that tax policy affects market returns, historical evidence suggests that it is the business cycle that ultimately determines stock-market direction, not tax policy. In fact, over the past 100 years, taxes have been increased just 17 times, and just seven times in the post World War II period.

Average market returns on the years immediately following a tax hike have been extremely strong, with the S&P 500 returning 18% during the first year after a tax hike. Not only that, but higher levels of tax are not an impediment for dividend-paying stocks. By contrast, market performance is generally weaker in the years immediately following tax cuts—largely because the economy is weaker in those years, not because of tax policy.

While the debate over the fiscal cliff is garnering all the headlines, the economy is showing signs of gradual improvement. Capital expenditures have been growing at a decent clip, outpacing the rate exhibited during the economic expansion of the 1990s and 2000s.

Personal consumption growth has also been picking up as consumer attitudes and employment prospects have improved. House prices have been moving higher. All of this should support US economic growth in 2013 of between 2% and 2.5%.

For a sustained bull market, we’ll need to see a little more clarity on both sides of the Atlantic on fiscal issues, and China's stimulus will need to kick in. In the meantime, I continue to recommend that investors focus on dividend stocks, particularly those companies that have a strong track record of consistently growing their dividend—a sure sign of outperformance in the long run.

Stocks that are in the best position to grow their dividends are the ones with a relatively low dividend payout ratio and solid balance sheets, many of which are in the health care and consumer staples sectors.